Broker Check

Dividend Strength Revisited and Potentially Cooling Inflation

| July 04, 2022

Our clients and readers know how Cornerstone as a firm believes in the power of dividends, especially stocks of companies that grow their dividends. This philosophical belief in dividends became even more important going back to last year, as we anticipated the inflationary environment that we are experiencing now.

Just last week we had a real-world example about the power of dividends and companies returning cash to shareholders that allows us to delve into this topic a bit more. Last Monday, several major banks announced dividend raises after passing the Federal Reserve's annual stress test. For longer term investors like us, it was a great reminder of why it can pay to hang on during short-term market swings.

One of these banks – Morgan Stanley (MS) – is a holding in our dividend growth model. It emerged as the big winner last week after announcing an 11% increase in its dividend along with a $20 billion share buyback after passing the Fed’s stress test.

To put this into perspective, Morgan Stanley’s repurchase authorization is nearly 15% of its entire market capitalization. We point this out because it is a great recent example of what our mantra has been for the past two years – owning stocks in high-quality companies that make products, actually do things, and generate real earnings that can be returned to shareholders via dividends and buybacks.

Historically speaking, dividends have made up about 40% of the S&P 500’s total return since 1930 (and there would be no return to speak of in the 2000s without dividends):

Drilling down more, if we separate dividend companies into five distinct categories (see below), it becomes apparent dividend growers and initiators have significantly outperformed every other type of equity going back to 1973:

When we talk about dividend growers, we mean corporations that have historically exhibited strong fundamentals, solid business plans, and a deep commitment to shareholders…like Morgan Stanley.  Thus, they are able to continually increase shareholder returns over time in the form of cash.

With last week’s dividend increases, we feel it's prudent to point out the two options investors have when it comes to income as part of your total return. That is, they can seek out dividend-paying stocks or they can buy bonds.

While the former may offer a slightly higher payout, the latter typically offers more protection of principle (not withstanding when the script is flipped, like this year). Still, looking solely at the payout level and capital structure fails to account for the instrument’s ability to protect buying power (i.e., inflation), which is really what retirement investing is all about.

Consider that if you buy 10-year Treasury note, locking in that rate can expose an investor to risk of loss of buying power, as we're seeing this year. For instance, at the beginning of 2022, a 10-year Treasury yielded about 1.6% and we're looking at inflation of 8.6%. That means there's a real return of minus 7%.

On the other hand, dividend payouts, which are often tied to net income, are reviewed on a regular basis (almost always annually). So, while there is risk that a company can cut its payout, if you own a high-quality company that can sustain through tough times, you're often rewarded with dividend increases that counter inflationary trends.

Let’s look again at Morgan Stanley increasing its dividend by 11%. That’s a 2.4% increase in buying power, even with the 8.6% inflation we’re experiencing. This dividend dynamic is in addition to buybacks, where companies pull shares out of the market, leaving the remaining shareholders with a greater claim on future income. When this happens, we also can see the share price grind higher, even if the market capitalization does not.

The $20 billion buyback announced last week by Morgan Stanley will pull nearly 15% of its outstanding shares out of the market. That allows its shareholders a greater claim on future earnings and dividend growth.

In the end, we acknowledge that risk and reward are tied at the hip. But we would argue that inflation risk outpacing locked-in bond yields is a risk that’s often overlooked.

This is why we have been on our soapbox, pounding the table about the power of dividends over time and their ability to protect our clients’ buying power. A steady stream of dividend payments allows us to keep our eyes more on the long-term picture, and less on the short-term price swings.

In fact, we think “big money” institutional investors feel the same way. That’s because since 2008, institutional investors have poured nearly $80 billion into equity income funds while individual investors have withdrawn nearly $100 billion over the same time:

It's not uncommon for institutional investors to be ahead of the general public, is it? Kidding aside, this nearly $200 billion gap is astonishing.

We've mentioned several times how investors are emotional with their decisions and tend to gravitate to what they think is safe, like bonds. While that may make them feel better about their portfolios, it’s a mirage because the facts (i.e., dividend growth stocks are better income-producing investment vehicles than bonds) often don’t align with that sense of security, as we've seen this year.

Inflation Cooling?

Two data points may be showing a bit of light at the end of the tunnel regarding the current economic environment.

We mentioned a few weeks ago how the M2 measure of money supply was an important metric for understanding whether inflation would cool down or heat up. Well, last week the Fed released new data, and from our point of view it was welcome news as the monetary surge propelling inflation to a four-decade high seems to be slowing.

That’s due to the amount of M2 money supply in circulation rising just 0.1% in May. As a result, the 12-month change fell to 6.6%, which is the slowest growth rate since the pre-pandemic days of 2019. To put this in perspective, 6% growth is considered normal, historically.

Thus far in 2022, the M2 money supply has grown at a modest 3.1% annualized rate, which is about half of the historical norm. Comparatively, the M2 measure of money supply grew at an 18% annualized rate from 2020-21. While it will take multiple years for our economy to fully digest all the excess purchasing power of money that is in the system, this is a welcome sign that could indicate inflation decreasing in the future.

This M2 money supply data also came at the same time as a few other good economic datapoints from an inflation perspective. Last week investors began to see demand destruction from soaring energy prices. Combine that with some lucky farm-friendly weather around the globe, and it could mean oil, natural gas, and food-related commodity prices may have peaked in early June.

The data supporting this is in the CRB Index, a broad index tracking 19 major commodities, which decisively broke its 50-day moving average uptrend at 312.29, signaling a top and potential move lower to its 200-day moving average of around 266:

Commodity prices must come down first before inflation can really decrease. And this is the first commodity indicator showing the demand destruction peak. So, this is bullish news.

Also, last week we saw natural gas prices top out on June 6, at $9.32. That breaks a sharp upward trend as European natural gas futures price fell 33%:

Lastly, there’s good news on the oil front. We saw West Texas Intermediate crude oil fall back to its key 50-day moving average support at around $107.00 a barrel.

As we all know, commodities are volatile and just because they have breached near-term uptrend lines does not remove the risk of another spike or set of spikes to come. Still, these are strong leading indicators of demand destruction in the market. When considered with the decrease in the M2 measure of money supply, these events may help ease inflationary pressure.

But only time will tell.

Securities sold through CoreCap Investments, LLC.  Advisory services offered by CoreCap Advisors, LLC.  Cornerstone Financial and CoreCap are separate and unaffiliated entities.